AP Microeconomics Course Review Guide PDF

AP Microeconomics Name: Course Review Guide Period: Date: UNIT 1: Thinking Like an Economist Economics: The study of the Choices that we are forced to make every day because...

AP Microeconomics Name: Course Review Guide Period: Date: UNIT 1: Thinking Like an Economist Economics: The study of the Choices that we are forced to make every day because of scarcity. Simply put, economics is simply the study of how society manages its scarce resources, i.e. its choices and trade-offs. ​ Thinking Like an Economist: ​ Humans are rational and act in their self-interest. ​ Decisions are made on the basis of their perceived costs and benefits. ​ Thinking is done on the margin, i.e. on the basis of the next choice (not the past). ​ People respond to incentives (although not always as intended). ​ Using simplifying assumptions and modeling. ​ Applying economic thinking to “non-economic” situations (e.g. AIDs in Africa). ​ Positive Economics: How things are. ​ Normative Economics: How they Should be. ​ An Economic System: “The process whereby choices are made as to how goods and services are produced and distributed to fulfill people’s unlimited wants and needs in the face of scarcity.” ​ Unlimited wants and needs: We always want/need more things and more time. ​ Scarcity: While our wants and needs are unlimited, our resources are limited. ○​ Resources (in economics): Land, Labor, Capital, and Entrepreneurship. ​ Choices: Scarcity forces us to make choices that involve trade-offs. ○​ Societal choices: Guns (military spending) vs Butter (social programs) ​ Choices are evaluated on the basis of costs and benefits at the margin. ○​ All costs lie in the future ○​ Ignore “sunk costs” which have already been paid and are not recoverable. ​ Not in an economist’s mindset: Walk out of that shitty movie! ​ Opportunity costs: the cost of (only) the next best option; what we have to give up by making a choice. Don’t include costs that we would require regardless like food or clothing when we evaluate the opportunity cost of attending college. ​ Goods and services: Goods are tangible; Services expire after the initial consultation. ​ Produced and Distributed: Three Key Questions: ○​ 1) What we make, 2) How we make it, and 3) Whom it is for. ○​ Who makes these choices distinguishes a Market Economy from a Command Economy.  ​ Market Economies: Decision-making around production and consumption are made by many firms and individuals. ​ The importance of Incentives and Property Rights. ​ Adam Smith and the Invisible Hand: When left alone, rational individuals will work in their self-interest, which almost magically will guide society to an optimal allocation of resources via the mechanism of price. ​ In a Market Economy, Allocation is done on the basis of price. ​ Command Economies: Factors of Production are owned the by government which makes the decisions around how they are utilized and how Goods are Distributed. ​ Mixed Economies: A Combination of the two, e.g. Capitalism plus a Social Safety net. ​ Capitalism: ​ Four Basic Tenets: ○​ Private Ownership. ○​ Voluntary Exchange. ○​ Profit-Motive. ○​ Competition. ​ Positives: Smaller Government (less Regulation and Lower taxes), product quality and innovation, lower prices, wealth creation. ​ Negatives: Exploitation of workers and the environment, profits before people, corruption. ​ Negative Societal Outcomes: ○​ Consumerism: a desires economy, being made to feel bad about oneself and then shopping to feel better, selling products on the basis of perceived lifestyles instead of their attributes  ​ “We buy things we don’t need with money we don’t have to impress people we don’t like.” ​ Wealth Inequality: The top 10% of people in the US own 70% of the country’s wealth. Inequality is made worse by disparity in stock ownership and restrictions in housing. ​ Measures of Income Inequality: ​ Lorenz Curve ​ Gini Coefficient ○​ A / (A+B) ​ The Production Possibilities Frontier (PPF): a simple 2-dimensional model of an economy’s production choices, assuming the maximally efficient use of its fixed resources and technology. The PPF encompasses the economic ideas of: ​ Scarcity ​ Efficiency ​ Trade-offs / Opportunity Costs ​ Economic Growth ​ Impact of Technology  ​ Efficiency: Points along the PPF. ○​ where you can’t make any more of one thing without taking away from the other, i.e. without incurring an opportunity cost. ​ Economic Law of Increasing Opportunity Costs: as you make more and more of a given product it starts getting more and more expensive as you have to give up more and more of the other because of the use of less and less suitable resources. ○​ “Luigi ain’t good at making robots!” ​ Economic Growth: Pushes the PPF outward / Economic contraction pushes it inward. ○​ Changes in resources (Land, Population). ​ Changes in Technology: While impacting the production of one product directly, it also helps the production of the other as resources can be shifted to the other product. ​ Comparative Advantage and Trade: Countries should search for Comparative Advantage and then Specialize and Trade. ○​ Trade makes everyone better off as you can push the PPF outward for both Parties. ○​ US and China: Toys and Planes ​ Four Steps: 1)​ Populate your Grid. 2)​ Calculating Unit Opportunity Costs: “Other Goes Over.” a)​ For Input problems, convert into Outputs over a common time frame, e.g. 24 hours. 3)​ Determine Comparative Advantage: Who has the Cheapest Opportunity Cost? 4)​ Determine the Price for Trade: must benefit both countries to occur. a)​ Lies between the Opportunity Costs for the two countries. Images Pages Jenn 50 25 Jeff 30 60 ​ Consumer Choice ​ Cost-Benefit Analysis ○​ “Yes/No” Questions: Compare Total Benefit vs Total Cost. ○​ “How Many” Questions: Compare Marginal Benefit vs Marginal Cost.  ​ Utility: A Measure of Consumer Satisfaction (Benefit). ○​ “The Rule of Diminishing Marginal Utility” – the Additional Utility of a Good Decreases the more of it I Consume. ​ The Utility of that First Slice of Pizza vs a Fifth Slice of Pizza. ​ Budget Constraints and the Optimal Consumption Bundle of Multiple Products. ○​ Comparing the Marginal Utility per Dollar not simply the Marginal Utility. ​ to gauge our highest “bang for the buck between 2 goods.” ○​ Compare MU1/P1 with MU2/P2 and keep adding the Good with the higher ratio until the ratios become equal (which they ultimately will because of diminishing marginal utility). UNIT 2: Demand and Supply. ​ Demand – Quantity of a product consumers are willing (and able) to buy at various prices. ​ vs. Quantity Demanded – the amount demanded at a specific price. ​ Change in Quantity Demanded – a move along the Demand Curve in response to a change in Price. ​ Change in Demand – a shift of the entire curve in response to a change in conditions. ​ In response to a change in price, there is only a change in Quantity Demanded, not a change in Demand. ​ [The exact same ideas hold for Supply and Quantity Supplied] ​ Law of Demand: Price and Quantity Demanded have an Inverse Relationship. ○​ As the Price goes Up ⇒ the Quantity Demanded goes Down. ​ Law of Supply: Price and Quantity Supplied have a Positive Relationship. ○​ as the Price goes Up ⇒ the Quantity Supplied goes Up. ​ Market Demand and Supply Curves are the Horizontal Summations of the Individual Demand and Supply Curves. ​ Equilibrium Price and Quantity is the point where: ○​ The Demand and Supply curves intersect. ○​ The Quantity Demanded by Consumers is the same as the Quantity made by Producers. ○​ Allocative Efficiency is achieved, i.e. Total Surplus is Maximized.  ​ Demand Shifters ​ Tastes and Preferences ​ Prices of Related Goods ​ Income ​ Population ​ Expectations ​ Supply Shifters ​ Prices of Inputs ​ Number of Producers ​ Technology ​ Taxes / Subsidies ​ Expectations Panel (a) is an outward demand shift, for example, a positive change in preferences (ice cream makes you smart), the result of which is that price and quantity both increase. Panel (b) is an inward demand shift, for example, a loss of population due to war, the result of which is a decrease in both price and quantity. Panel (c) is an outward supply shift, caused for example by an increase in technology, the result of which is an increase in quantity and a decrease in price. Panel (d) is an inward supply shift, caused for example by an increase in input prices, which results in a decrease in quantity and an increase in price. ​ Demand (Supply) Elasticity – The Responsiveness of Quantity Demanded (or Quantity Supplied) to a Change in Price. ○​ % Change in Quantity / % Change in Price ○​ Simple vs Midpoint Calculations *** Be Sure that you can Calculate in both Manners. *** Simple Midpoint ○​ Elastic Goods >>> more responsive to a change in price (more horizontal). ​ Consumer Goods (many substitutes). ​ Voluntary Purchases. ​ Absolute Value > 1. ​ Inelastic Goods >>> less responsive to a change in price (more vertical) ○​ Necessities. ○​ Products with few Substitutes. ○​ Absolute Value < 1. >> Insulin is Insensitive is Inelastic. *** Know your Elasticities from Page 508 of the Textbook! *** ​ Cross-Price Elasticity: % Change in the Demand for Product A in Response to a % Change in Price for Product B. ○​ If Positive, then Products are Substitutes. ○​ If Negative, then Products are Complements. ​ Income Elasticity: % Change in Quantity Demanded in response to a % Change in Income. ○​ If Positive, then the Product is a Normal Good. ○​ If Negative, then the Product is an Inferior Good. ○​ If 1, then Income Elastic (voluntary purchases like vacations) ​ Elasticity does NOT EQUAL Slope. ​ Elastic: Top Left. ​ Unit Elastic: Equal to 1. ○​ Where MR = 0. ​ Inelastic: Bottom Right. ​ Total Revenue Test: TR = Quantity x Price ​ If P goes Up and TR goes Up >> the Product is Inelastic. ​ If P goes Up and TR goes Down >> the Product is Elastic.  ​ Total Surplus – A Measure of Societal Economic Well-being. ​ Consumer Surplus – What I did Pay versus What I would have Paid. ○​ The Area Above the Price Line and Below the Demand Curve. ​ Demand = A Consumer’s Willingness to Pay. ​ As Price goes Up, Consumer Surplus Declines and vice versa. ​ Producer Surplus – What I got Paid versus What I Would Have Worked for. ○​ The Area Below the Price Line and Above the Supply Curve. ​ Supply = A Producer’s Marginal Cost. ​ As Price goes Up, Producer Surplus Increases and vice versa. ​ Total Surplus = Consumer Surplus + Producer Surplus ​ ​ = Value (Buyer) – Cost (Seller) >> You Keep Doing Transactions as Long as this Value is Positive. Producers can try to capture Consumer Surplus through Product Differentiation and Branding, and the offering of add-ons or product options like on a car. ​ Taxes: “The cost of civilized society.” ○​ The Impact is the same regardless of whether the tax is put on the Consumer or Producer. ​ On Consumer: Shifts the Demand Curve inward by the size of the tax. ​ On Producer: Shifts the Supply Curve inward by the size of the tax. ​ Tax Incidence: whichever group (consumers or producers) is less responsive to a change in price (i.e. is more inelastic) incurs the greater percentage of the cost of the tax. ​ Draw using a Tax Wedge. ○​ Net Effects: ​ Quantity (economic activity) Falls. ​ Price Paid by Consumers Increases. ​ Price Received by Producers Falls. ​ Government Collects Revenue. ​ Deadweight Loss is Created. ​ Those exchanges which no longer occur after the tax is levied. ​ Voluntary Trade is Beneficial as it Increases Total Surplus. ○​ Iso-land and World Trade ​ Domestic Price vs. World Price: ​ Determines whether a country is an Importer or Exporter. ​ If the Domestic price is Lower, then Export to the World. ​ If the Domestic Price is Higher, then Import at the Lower World Price. 1)​ The Benefit of Exports: Surplus Production is Exported and Total Surplus Goes Up. 2)​ The Benefits of Imports: Shortages are Covered and Total Surplus is Increased. *** Be able to demonstrate this on a graph.***  3)​ Effects of Tariffs – Domestic Quantity Supplied Increases, Quantity Demanded Falls, Consumer Surplus Falls, Producer Surplus Rises, and Gov’t Revenue and DWL are both Produced. ​ Light Blue Triangles (2&4) = Deadweight Loss ​ Disequilibrium Conditions: ○​ Forced moves away from the Market Clearing/Equilibrium Price. ○​ Price is prevented from being used by the Invisible Hand to allocate scarce resources and ultimately achieve equilibrium. ​ Result: Surpluses and Shortages ⇒ For a change in price, follow the Demand and Supply Curves to find the new Quantity Demanded and new Quantity Supplied. Binding Floors and Ceilings: Prevent Price from Regaining Equilibrium. * Price Floors (above equilibrium price) – e.g. Minimum Wage * Price Ceilings (below equilibrium price) – e.g. Caps on Prices/Rent Control UNITS 3/4: The Theory of the Firm under Different Market Structures. ​ The Role of the Firm is to Maximize Profits, which can always be found where MR = MC. ​ Profits = Total Revenue - Total Costs. On a graph, the rectangle is defined by (P - ATC) X Q. ○​ Accounting Profit = Total Revenue - Explicit Costs. ○​ Economic Profit = Total Revenue - Explicit Costs - Implicit Costs. ​ Implicit Costs = Opportunity Costs, i.e. salary that could be earned elsewhere, etc. ​ Accounting Profit > Economic Profit. ​ If Economic Profit is Zero, then Accounting Profit is Positive. ​ Short Run vs Long Run: ○​ In the Short Run, at least one input (Land, Labor, or Capital) is Fixed. ○​ In the Long Run, all inputs are variable. ​ The Production Function: ○​ Graph of Output as a Function of Inputs (typically Labor as it is most easily adjusted). ​ Graph it in total terms: ​ The Production Function speeds up initially as specialization occurs, but then the rate of growth slows as the Marginal Product of the Input begins to decrease– Diminishing Marginal Product (of Labor). ○​ “Too many cooks in the kitchen (getting in each other’s way).” ​ The Shape of the Production Function defines the Shape of the Marginal Cost Curve. ○​ Down Initially due to Efficiency, then ever-increasing due to Diminishing Marginal Product. ​ If MC is increasing, then Marginal Product is diminishing. ○​ “The Nike Swoosh.”  ​ Different Types of Costs: ○​ Total Costs = Fixed Costs + Variable Costs. ○​ Fixed Costs = Do Not Change as Output Changes, e.g. Factory Rent. ○​ Variable Costs = Change with a Change in Output, e.g. The Amount of Labor. ○​ Average Total Cost = TC / Q. ○​ Marginal Total Cost = ∆ TC / ∆ Q. ​ The Big 4 Short-Run Cost Curves (under Perfect Competition) ​ Maximizing Profits under Short-Run Perfect Competition. ○​ Finding where MR = MC (as for all market structures). ○​ Under SR Perfect Competition, MR = Price. “MR. DARP” ​ If Price > minimum of ATC ⇒ Profit ​ If Price = minimum of ATC ⇒ Break-even ​ If Price < minimum of ATC ⇒ Loss ​ If Price < minimum of AVC ⇒ Shut Down ​ The Shut Down Rule 2 Ways: * If P = MR is less than AVC. * If TR < Variable Cost. ​ Returns to Scale: Relationship between a change in Inputs and the resulting change in outputs. ​ Increasing: Output grows by more than a change in Inputs. ​ Constant: Output grows at the same rate as a change in Inputs. ​ Decreasing: Output grows by less than a change in Inputs. ​ In the Long Run, all Inputs are Variable. Firms must decide: ○​ What level of Output to Produce? ○​ Then, How to Optimize/Minimize their ATC of Production at that level of desired production? ​ I.e. How big should my factory be? ​ Economies of Scale: Relationship between Output and ATC. ○​ Economies of Scale: LR ATC Decreases as Output Increases. ○​ Constant Returns of Scale: LR ATC does not change as Output increases. ​ Minimum Efficient Scale: Lowest cost ATC for the desired output. ○​ Increasing Returns of Scale: LR ATC increases as Output increases. ​ In the Long Run, if MR < ATC, then Exit the Business. ​ If Profit > 0, then other firms will enter the market driving LR Economic Profit to 0. ​ The relationship between the Industry D-S curves and the Individual Firm’s Cost Curves. ​ Under Perfect Competition: ​ All Firms are Price-Takers. MR = P = Demand. “MR. DARP.” ​ The Economy Experiences Allocative Efficiency at Equilibrium (Demand = Supply). ​ Economic Profits = 0 in the Long Run due to Entry and Exit by competitors. ​ Under Imperfect Competition: ​ Firms have varying Degrees of Market Power. ○​ Not Just Price-Takers. ○​ Price > MC, so they Produce Q < Equilibrium Quantity. ○​ Typically Earn Positive Economic Profits. ​ But Market Power is NOT Absolute–Firms are still Subject to the Demand of Consumers. ​ Market Power naturally does not Self-Correct due to Barriers to Entry. ​ Barriers to Entry: ​ Control of a Scarce Resource. ​ Economies of Scale. ​ Government-Created Barriers. ○​ Patents and Copyrights. ​ Imperfect Competition Market Structures: ○​ Monopoly. ○​ Oligopoly. ○​ Monopolistic Competition. ​ Monopoly: Differences in the Demand Curve vs Perfect Competition ​ Because the Demand Curve is Downward Sloping, to Sell More, the Monopolist Must Cut Prices on All Units Sold. ​ Therefore MR lies below the Demand Curve at every point. ​ For a Natural Monopoly, the ATC Curve does not curve back upward but instead converges asymptotically to the MC curve (which is Horizontal). ​ Welfare Cost of Monopoly: The decision to produce where MR = MC results in a Quantity that is sub-optimal, i.e. it is less than the equilibrium quantity and results in DWL. The monopolist sets the price at the point of the demand curve corresponding to the sub-optimal Q. ​ Price Discrimination: a pricing strategy that charges consumers different prices for identical goods or services in order to increase profits. ○​ Differs from a Single-Price Monopolist as the Producer is Segmenting the Demand Curve to charge each Segment a Different Price, e.g. Business Travel vs Vacation Travel, Movie Tickets. ○​ Perfect Price Discrimination: Matching the Price to each customer. ​ Eliminates Consumer Surplus entirely. ​ Eliminates DWL–is Allocatively Efficient. ​ Oligopoly and Game Theory: ​ A Dominant Strategy for Player 1 is better for all outcomes regardless of what Player 2 does. ​ A Nash Equilibrium is an Outcome where Neither Individual has an Incentive to Change her Actions given the Possible Actions of the Other. ​ Monopolistic Competition: Many Sellers of (Slightly) Differentiated Products. ​ In the short run, firms price like a monopolist. ○​ Because P > MC, firms are incentivized to differentiate their products. ○​ Use of Advertising and Branding. ​ In the long run, free entry and exit drive profits to zero like under perfect competition. ○​ Entry and Exit cause the Firm’s Demand and MR curves to shift in or out to reflect its changing share of the market. LR equilibrium occurs where the ATC intersects the Demand Curve at the Price where MR = MC but Profits are Equal to Zero. UNIT 5: Factor Markets ​ The Circular Flow Diagram ​ Factors of Production: ○​ Land ○​ Labor ○​ Capital ○​ Entrepreneurship ​ Firms represent Demand and Households represent Supply in Factor Markets. ​ Factor Markets are assumed to be Perfectly Competitive–Buyers and Sellers are Price-Takers. ​ Marginal Product (of Labor) = Additional Output from an Additional Unit of Input. ​ Marginal Revenue Product = the Dollar Value of that Additional Output. ○​ MRP = MP X P (of the Product) ○​ *** This is the Demand Curve for a Factor. *** ​ Marginal Factor Cost: The Additional Cost of employing an Additional Unit of a Factor of Production. ○​ Rental Rate: The cost of Land or Capital. ○​ Wage: the cost of Labor. ○​ In both cases, this cost is a Marginal Cost and is the Horizontal Supply Curve of the Firm. ​ The Profit-Maximizing Rule for Employing Factors of Production: ​ Continue adding additional units of a Factor until the MRP = MFC, e.g. MRPL = W. *** Equivalent to MR = MC but be sure to use the appropriate terminology/labelling! *** ​ The Supply of Labor – the Trade-off between Wages and Leisure. ○​ Substitution Effect: A Higher Wage increases the Opportunity Cost of Leisure. ○​ Income Effect: The Higher Wage allows you to work less to consume the same amount of leisure. ​ A Firm’s Cost Minimization Rule – Keep adding that Factor that gives the “biggest bang for the buck.” ⇒ Compare the Marginal Factor Product on a Dollar Adjusted Basis. MPL / w vs. MPK / r *** Cost is Minimized when they are Equal *** ​ Monopsony: Not a Perfectly Competitive Factor Market as there is only 1 Buyer of Labor. ​ To Increase the Amount of Labor, Must Raise the Wage for All Employees. ​ MFCL > W. While a Monopoly tracks up to the Demand Curve to set a Higher Price, a Monopsony tracks down to the Supply Curve to set a Lower Wage. UNIT 6: Government and Market Failure ​ Market Failures: Economic Conditions which prevent Allocative Efficiency. ○​ Market Power/Monopoly. ○​ [Asymmetric Information]. ○​ Externalities. ○​ Public Goods. ⇒ Governments can help in these circumstances. ​ Externality: A Cost or a Benefit that is External to a Transaction between a Producer and a Consumer. This Cost or Benefit can result from either the Production or the Consumption of the Good or Service involved. ○​ Internalizing the Externality: Adding the External Cost (Benefit) to the Private Cost (Benefit) in order to assess the true cost to society (in order to judge Societal Allocative Efficiency). ​ MSC = MPC + MEC ○​ Marginal Societal Cost = Marginal Private Cost + Marginal External Cost ​ MSB = MPB + MEB ○​ Marginal Societal Benefit = Marginal Private Benefit + Marginal External Benefit ​ Negative Externalities Negative Productive Externality Negative Consumptive Externality ​ Positive Externalities Positive Production Externality Positive Consumptive Externality ​ Deadweight Loss always Points toward where Societal Allocative Efficiency would be. ○​ For Negative Externalities: To the Left (we want to produce/consume less!) ○​ For Positive Externalities: To the Right (we want to produce/consume more!) ​ Government Solution to Externalities: ○​ Antitrust legislation. ○​ Regulation and Environmental Standards. ○​ Pigouvian Taxes/Subsidies – using Per Unit costs/payments equivalent to the MEC or MEB to encourage or discourage production/consumption. ​ Per Unit Costs/Benefits Impact Quantity by Impacting Marginal Cost or Marginal Revenue. ​ Lump Sum Costs/Benefits are equivalent to Fixed Costs so they only Impact a Firm’s Decisions to Enter or Exit a market. ○​ Binding Price Ceilings to counter High Prices under Monopoly ○​ Binding Price Floors to counter Low Wages under Monopsony. ​ Different Types of Goods ○​ Evaluating Goods on 2 Metrics: ​ Excludability – Goods Can’t be Consumed unless they are Paid for. ​ Rival in Consumption – Goods Can’t be Consumed by more than One Person. Excludable Non-Excludable Rival Private Goods Common Goods (Consumer Goods) (Fisheries) Non-Rival Artificially Scarce Goods Public Goods (Pay-for-View) (Defense) ​ Forms of Inefficiency: ○​ Non-Excludable Goods – Producers not Incentived to produce ⇒ Less than Efficient Quantity. ​ The Tragedy of the Commons: Over-consumption of a resource. ​ Imposing Quotas ​ Entry Fees / Congestion Charges ○​ Artificially Scarce Goods – Price > MC so Quantity Consumed in less than Optimal. ○​ Public Goods – acc. to Economists, the Provision of Public Goods is a Crucial Role of Gov’t. ​ No incentive for private producers to supply a public good as it not rationale for consumers to pay for it. ​ “The Free Rider Problem.”